Some people don’t know, but there is a net investment income tax of 3.8% that applies to some of your income. Today, I want to discuss what it is, how we can reduce its impact, and how we can save money.
Let’s dive right in:
Net Investment Income Tax (NIIT)
The net investment income tax is imposed on investment income if the modified adjusted gross income (adjusted gross income + foreign income exclusion) is more than $200,000 for single filers or $250,000 for those married filing jointly.
This tax is applied to the lower of:
- Modified adjusted gross income
- Net investment income
Example:
Say you have a modified adjusted gross income of $220,000. Your net investment income is $40,000. You are single. How much tax will you pay?
- $220,000 – $200,000 = $20,000 (above the threshold)
- The amount is the lesser of $20,000 (above the threshold) or $40,000 of net investments.
- $20,000 × 0.038 = $760 of tax.
Here are some common examples of investment income:
- Gains from the sale of stocks, bonds, and mutual funds.
- Capital gain distributions from mutual funds.
- Gain from the sale of investment real estate (primary residence is excluded, up to $250k/$500k of gain).
- Dividends
- Interest
So, how do we save some money on taxes?
- Interest
Municipal bond (received from city or state) interest is tax-exempt. So, if you have a lot of interest income, consider shifting that to a municipal bond ETF and avoid the NIIT.
However, you would have to do some math to ensure that the yield × (1 – marginal tax rate) is lower than the municipal interest yield. Remember—the goal is not to minimize taxes but to maximize the after-tax yield.
- Dividends
Dividends count toward the 3.8% NIIT. As a result, if you want to minimize the impact of NIIT, you can rebalance the portfolio to emphasize growth stocks over dividend paying stocks. However, make sure that your asset allocation is not impacted as a result.
- Lower your adjusted gross income
If you are below the income threshold, you don’t pay the net investment income tax.
So, make sure to contribute to different accounts that lower your income, like 401(k), 403(b), 457(b), SEP IRA, Traditional IRA (if no 401(k) plan), and HSA.
- Installment sales
If you can, spread the gains from the sale of investment property over multiple years to reduce the impact on your taxable income.
- 1031 Exchange
If you have an investment property, consider a 1031 like-kind exchange to reduce the impact of the capital gains on the NIIT.
I hope you enjoyed this one. Any content ideas? Feel free to reply back!
See you next Saturday.